The most successful approach I’ve found when picking shares has actually been one of the simplest: looking for companies with strong economic moats.
What is an ‘economic moat’?
An ‘economic moat’ is another name for a competitive advantage. It is a feature that is hard to replicate which protects a company’s earnings from the onslaught of competition. Just like a moat protects a castle.
Companies with economic moats can be an investors’ best friend. By being insulated from competition companies, they are able to generate above-average returns on capital. By reinvesting that cash, these companies can compound and grow dramatically over time.
Many of the best-performing ASX-listed companies have strong economic moats. If we pick these companies as a core part of our portfolio, we stand a good chance of earning better returns.
The 4 types of economic moat
In his book ‘The Little Book That Builds Wealth’ author Pat Dorsey outlines four categories of economic moat to look for when picking a company to invest in:
- Intangible assets
- Customer switching costs
- The network effect
- Cost advantages
Intangible assets can include brands and patents. Blood product company CSL Limited (ASX: CSL) is an example of a company which, through years of research and acquisitions, has created a valuable portfolio of patents and product licences.
Accounting platform Xero Limited (ASX: XRO) is an example of a company with high customer switching costs. Because there is a lot of time and hassle involved with changing to a new accounting system, the cost to switch can be prohibitive.
Despite the rise of Linkedin, jobs platform Seek Limited (ASX: SEK) has proved to be a robust example of the network effect where growing additional users creates more value for other users.
While JB Hi-Fi Limited (ASX: JBH) is an example of a company that has thrived using cost advantages to reduce prices for consumers and win market share.
Growing your money with great companies
I think economic moats are useful criteria for picking decent companies that will earn high share returns. However, to really get the best result we need to have patience; the patience to buy shares at bargain prices and the patience to let returns compound for long periods. That is the hard part.
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The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. and Xero. The Motley Fool Australia has recommended SEEK Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.